On January 6, 2016, the staff of the SEC’s Division of Investment Management issued a Guidance Update outlining the staff’s views and recommendations regarding oversight of mutual fund distribution fees and the payment of fees to financial intermediaries characterized as non-distribution related to subtransfer agent, administrative, sub-accounting and other shareholder servicing fees (collectively, subaccounting fees).
The Guidance Update follows sweep examinations conducted by the SEC’s Office of Compliance Inspections and Examinations to assess whether mutual fund payments to financial intermediaries constitute “distribution-in-guise.” That is, whether some or all of the payments characterized as sub- accounting fees were, in fact, for distribution-related services, paid out of fund assets, but not pursuant to a Rule 12b-1 plan and thus, impermissible under the 1940 Act. Rule 12b-1 prohibits mutual funds from engaging, directly or indirectly, in the financing of any activity which is primarily intended to result in the sale of fund shares except pursuant to a written plan that meets the requirements of Rule 12b-1.
In the Guidance Update, the staff’s broad recommendations include the following:
- whether or not a fund has a 12b-1 plan, the fund’s board should have a process in place reasonably designed to evaluate whether a portion of sub-accounting fees is being used to pay directly or indirectly for distribution;
- as part of this process, advisers and other relevant service providers should provide sufficient information to inform the board of the “overall picture” of the fund’s distribution and servicing arrangements, including how the level of sub-accounting fees may affect other payment flows (such as 12b-1 fees and revenue sharing) that are intended for distribution; and
- advisers and other relevant service providers should inform boards if certain activities that are potentially distribution-related exist in connection with sub-accounting fee arrangements, and if they do, boards should evaluate the appropriateness and character of those payments with heightened attention.
In addressing how a board may seek to appropriately characterize fees, the staff cites the 1998 letter from the SEC staff to the Investment Company Institute regarding mutual fund supermarket fees (commonly referred to as the “supermarket letter”), noting that the same types of factors and analysis described in the supermarket letter may serve as a useful framework for the board’s process. In addition, the staff noted that boards might generally consider also requesting relevant additional information from the adviser and other service providers, including:
- information about the specific services provided under the mutual fund’s sub-accounting agreements;
- the amounts being paid;
- if the adviser and other service providers are recommending any changes to the fee structure or if any of the services provided have materially changed;
- whether any of the services could have direct or indirect distribution benefits;
- how the adviser and other service providers ensure that the fees are reasonable; and
- how the board evaluates the quality of services being delivered to beneficial owners (to the extent of its ability to do so).
Regardless of the specific process employed to make an evaluation of fees, the SEC staff recommends that boards have a process in place reasonably designed to provide them enough information that they can make an informed judgment as to whether fund-paid fees are being used to pay directly or indirectly for distribution, noting that there are “a number of reasonable approaches” but, “in the absence of any such process, it is unclear how a board might make an informed judgment” regarding the fund’s compliance with Rule 12b-1. Notably, the SEC staff suggested that funds should have “explicit policies and procedures as part of their Rule 38a-1 compliance programs designed to prevent violations of Section 12(b) and Rule 12b-1.” In this regard, the Guidance Update states that, as part of the distribution-in-guise sweep exams, the staff observed that many funds did not have such “explicit policies and procedures.”
Other staff observations from the sweep exams are noted in the Guidance Update as indicia that may raise concerns that a payment, though ostensibly not for distribution-related activities, may in fact be (at least in part) a payment for such services. These situations or arrangements include:
- distribution-related activity is conditioned on the payment of a sub-accounting fee;
- a fund has not adopted a 12b-1 plan and does not impose sales loads;
- a fund uses a tiered payment structure for a number of services in which intermediaries are paid first from Rule 12b-1 fees, then fund-paid sub-accounting fees and finally any balance is paid by the adviser or an affiliate from revenue sharing, raising the question of what services the fund is actually paying for and whether any fund-paid fees reduce or subsidize fees that the adviser or other service provider might otherwise be responsible for;
- there is a lack of specificity of services provided by an intermediary or payments for both sub- accounting and distribution have been bundled into a single contract. As to this particular circumstance, the staff noted that, in some cases, boards have evaluated whether the overall payment for a bundled set of services or activities is a payment that is primarily for distribution- related services, an approach that is, in the staff’s view, “inconsistent with the requirements of Rule 12b-1, which explicitly requires that any activity which is primarily intended to result in the sale of mutual fund shares be paid for through a 12b-1 plan, if paid from mutual fund assets.”
- the adviser and other service providers take into account distribution and sales benefits when recommending, instituting or raising sub-accounting fees;
- there are large disparities in the sub-accounting fee rates to intermediaries providing substantially the same set of services to the fund; and
- intermediaries sell additional “strategic sales data” to funds, their advisers or other service providers, providing information about fund investor demographics and other information about top sales partners and channels.
Recognizing that boards are typically not involved in the negotiation of agreements with intermediaries, the SEC staff maintains that boards should be able to rely on the adviser and other service providers “to affirmatively provide information about the existence of any of these activities or arrangements, as well as summary data about expenses and activities related to distribution-related activities.” In addition, the SEC staff notes its expectation that fund directors can receive and rely on the assistance of outside counsel, the fund’s chief compliance officer, or personnel of the adviser or relevant service providers, as appropriate, to assist them in evaluating payments to intermediaries. In the staff’s view, the board’s role should “focus on understanding the overall distribution process as a whole to inform its reasonable business judgment about whether sub-accounting and other mutual fund-paid fees represent payments for distribution, in whole or in part.”
The Guidance Update is available at: https://www.sec.gov/investment/im-guidance-2016-01.pdf.